Tuesday, July 28, 2009

Behavioral economics bills itself as an alternative to the standard economics approach which assumes people make decisions rationally.Behavioral econ doesn’t say we are totally irrational, it just shows that the devil is in the details.

Let me illustrate with one of my favorite topics – the obesity epidemic.The rational economic model describes the decision thusly (I love that word :-D): When Joe is deciding whether to eat the jelly donut or to go for a jog, he evaluates the various tradeoffs (gain the pleasure of eating the donut along with the cost of extra weight or gain the advantage of losing weight along with the cost of jogging) and decides accordingly.Free will and the free market allow him to make the decision that best meets his priorities.All is good.

The behavioral economic model describes it somewhat differently.Joe figures he can get the best of both worlds by eating the donut now (gain the pleasure of the donut) and starting his diet tomorrow (gain the advantage of losing weight).But then tomorrow he is faced with the same decision, and can put off the diet for “just one more day.”

The problem is twofold.What seems like an obvious hypocrisy is made possible by the fact that there are two different parts of the brain that make these decisions without coordinating with each other.One part of the brain makes decisions about what to do right now (a more instinctive, emotional center that is dominated by sensory experience).This brain wants the donut.

A different part of the brain decides what to do in the future (a more analytical center that can delay gratification for higher level objectives like health).This brain agrees to jog.

The way the two brains resolve their disagreement is to eat the donut now and agree to jog tomorrow.It’s like two different people.

The second part of the problem is that the decision making process is recursive.The next day when we are supposed to go for the jog that our logical brain promised, our emotional brain takes over (because it is again a "now" decision) and says “hey, I never promised nothin’.”And our logical brain is limited to complaining about the irresponsible emotional brain and again promising what to jog “next time.”

Behavioral economics recognizes that this can go on forever, even with the best of intentions.The solution is to add some emotional component to the process that favors the long term benefits.So for example with 401(k)s, we can counteract the emotional brain’s desire to enjoy our money NOW by making it a real pain to opt-out of contributing to the 401(k).Stickk.com makes us give money to charity (which is emotionally painful, especially when you give it to an organization you DISAGREE with) every time we eat a donut. These are artificial situations, but they can be effective by recruiting the emotional brain to help us do what our logical brain knows is best.